Episode 330 - Davidson Heath: How Are Index Funds Affecting Financial Markets and Corporate Governance?

0:03This is the Rational Reminder Podcast, a weekly reality check on sensible investing and financial decision-making from two Canadians. We're hosted by me, Benjamin Felix, Portfolio Manager at PWL Capital, and Mark McGrath, Associate Portfolio Manager at PWL Capital. Episode 330? That is correct. Episode 330, which is crazy in itself. Today, we're joined by a fellow Canadian who is currently living in Utah as a professor there. He's an assistant professor of finance at the University of Utah's David Eccles School of Business, and it is Davidson Heath. Super super interesting guy. He was a derivatives quant and trader prior to academia.

0:42He went to UBC out in British Columbia and also to Queens. Then he did an MBA at Chicago Booth, PhD finance from USC. Now he's in academia and he's got some incredible research on a bunch of different topics, but a large theme of what we talked about is index funds and how they're impacting price efficiency of stocks, how they're impacting corporate governance, how they're impacting the liquidity of stocks. And then we also talked a little bit about socially responsible investing. And that segment was super interesting. Yeah, it's hard not to spoil it in the intro, but there was a couple of mind-blowing comments and stats in there.

1:16So yeah, the whole episode was really, really good. Obviously, he's brilliant. Grew up in my neck of the way. I mean, you were born on the island too, but you mentioned that he was from Quadra Island. There's a population of 2 ,000 people on Quadra. My best friend happens to live there. What a small world. So it was really cool, but clearly brilliant, very well-spoken, great episode. Loved it. It is crazy though that this episode is three people, well, you're not from the island, I guess. Three people from BC, close enough. Two of us from Vancouver. I don't know, he was on Quadras, not on Vancouver Island, but in a very close area, British Columbia.

1:43Small world. Anyway, I think this is a super interesting conversation. We talked about Davidson's paper on index investing. The first paper that we talked about on a podcast episode, I don't know, years ago at this point. But when that paper came out, just talking about how index funds are not affecting price efficiency, I thought that was really interesting at the time. So it's pretty cool to get to talk to Davidson. We do mention during the conversation that he's actually the person that introduced me to Scott Cederberg's work, which obviously ended up being a couple of really interesting episodes with Scott.

2:10So thanks again to Davidson for that introduction. All right. I think that's enough of an intro for this. We can go ahead to our conversation with Davidson Heath.

2:22Davidson Heath, welcome to the Rational Reminder podcast. Thanks very much, Ben and Mark. It's a pleasure to be here. I am a big Rational Reminder fan and I rarely miss Pod, so this is a treat for me. That is very cool to hear. It's maybe worth mentioning while we're chatting about that, that you introduced me to, or at least told me about Scott Cederberg a while ago, and those turned out to be some pretty cool episodes. I'm sure the listeners thank you for that as well. Very good. All right, let's kick us off. We're going to start with your paper on index investing. The paper is literally titled On Index Investing.

2:51Why are active managers important to indexing? So, active investors create the liquidity in the market. And by definition, they're the ones who end up taking the other side of passive investors trading. And active investors also collect information and try to buy up stocks that are underpriced and sell or short stocks that are overpriced. And in so doing, they move the prices to being more correct. So, active managers also set the prices at which index funds buy and sell. And what are your model's predictions on how index investing affects information production about individual stocks? So in the model, as passive investing goes up, it just pulls out a larger and larger chunk of the stock's market cap, which previously was available to active investors to hold and to trade.

3:39Since active investing is a zero-sum game, the stakes are now smaller for the active investors to compete over. As a result, active investors do less trading and they gather less information about individual stocks. So when you look at this, how does index inclusion affect the composition of active and passive investors in a given stock? That's an important question because the key research question that we're trying to address, the effects of the rise of passive on financial markets, you need to separate the growth of index investing from all the other events that have happened over the same time period.

4:14That is, you want to avoid spurious correlations. So in the paper, we look at stocks that switch between the Russell 1000 and 2000 indices on a predetermined schedule. The Russell 1000 is the 1000 largest, that's the large cap index. And then the next stocks numbered 1001 through 3000 is the Russell 2000, the small cap index. Now, both of those indexes are market cap weighted. So if you go from the bottom of the 1000 to the top of the 2000, that produces a jump of about 2 % of the stock's market cap in passive fund holdings. And how does index investing affect investor behavior and stock price dynamics?

4:50We find that stocks that get a bump in this way to their passive holdings, they have higher trading activity, higher turnover relative to their float. They have higher short interest. They have higher volatility, their daily return volatility goes up, and they have higher correlation with the market as a whole. So stocks with more index ownership see those changes? That's right. And in some cases, it seems pretty clear and straightforward as to why the short interest component. Many index funds make back a sizable amount of their revenue on loaning out the stocks that they hold for short sellers to short.

5:28So it makes sense that index funds relative to active funds would create a bump in the supply of shares to be shorted, for example. The other outcomes, things like correlation with the market, return volatility, it's a little harder to see exactly what's causing what. So how do you measure information production, which is one of the things you guys are trying to figure out? So we look at three measures. We look at Google searches for the stocks ticker, views of the firm's SEC filings, think about their annual and quarterly reports, mostly on the SEC's Edgar website, and buy side analyst reports about that stock.

6:04That's really interesting. So it's literally how much are people looking at this stock and how much are they writing about it? Yeah, that's cool. What are your empirical findings on how index investing affects information production? For all three measures, when the stock gets a bump to their index fund holdings, we find that information production goes down. And how does it affect price informativeness? So the key question, of course, is really about information production about a stock is not itself an important thing on a society-wide level, what matters is how accurate or informative or efficient the stock prices are.

6:38So we measure price efficiency three different ways as well. We look at variance ratios. The variance ratio is this measure of random walkiness of the stock price. It goes back to if the ratio of your volatility, your one-day volatility to your 10-day volatility is about square root 10, then that says that your stock is relatively a random walk. And going back to Paul Samuelson way back in the 1950s, a properly anticipated price should be a random walk as the statement about price efficiency. So we look at variance ratios. We look at this aggregate mispricing measure that Rob Stambon co-authors constructed.

7:15And we look at post earnings announcement drift, how quickly new information is incorporated into the stock price. And on all three measures, we actually find zero change across the board. Random walkiness is a great term, by the way. I'm going to see if I can use that somehow. How is it that information production falls, but price informativeness is unaffected? So that's the key puzzling or interesting fact in the paper. Now, our model predicts this, but it is actually a very simplified and stylized prediction. The intuition is that as the active pie shrinks, as a larger and larger proportion of the stock's float is taken out of the active market by the index fund investors, The active pie is shrinking.

7:59So as a result, as we said, the returns to gathering information shrink, but the level of noise trading by uninformed or less informed active traders also shrinks as well. And as a result, the ratio in that active segment of noise trading to inform trading stays the same. And as a result, price informativeness, price efficiency is unchanged. I know you guys use a Grossman-Stiglitz framework, but this is the Grossman-Stiglitz paradox happening in real life. Exactly. Exactly. So it's a very stylized model. It abstracts from a lot of things, but I think Rosman Stiglitz is a classic for a reason. It captures some very deep intuitions that we like.

8:38Super cool. So what's your main conclusion on how index investing is affecting price efficiency? So I could say a lot of things here, but I would say first of all, that the model is very simple and stylized, but it captures some very reasonable intuitions on two sides. The first side is index funds have grown enormously. Passive investing has just grown by leaps and bounds. But index funds have a very strong incentive to minimize their effects on the stocks that they hold. In other words, to minimize market impact. Vanguard, State Street, and BlackRock have a ton of really, really smart, hardworking people who work there.

9:13And that's their job is to how can we minimize market impact. On the other hand, at the same time, active investors always have a strong incentive to search out mispricing or information and trade on it. That's what they do. And furthermore, I could say a former PhD student of mine, Da Wang, who now is a professor at Northeastern, his PhD thesis actually explored that as passive investing rises, which active managers drop out. And it turns out that it's disproportionately the worst performers. Those with the worst performance and the worst returns among active managers who see the most outflows are most likely to close up shop.

9:50So on both sides of the rise of passive, it makes sense that market quality and efficiency of financial markets should be pretty robust to the rise of passive investing. There are very strong forces on both sides that are pushing us back to equilibrium. Do you have a thought on at what point it becomes a problem? At what point passive becomes a problem in terms of price efficiency? So again, in our simplified stylized model, you go all the way up to 0.9999 of the market is passive and there's literally one guy with$1 and that guy sets the prices and things work out fine. I don't think we will ever get to that point.

10:25But I will also say I don't think we'll ever get to the point of it's going to tail off at some point. The strongest comment on this I could make is that people love to trade actively. And in fact, the main use of ETFs, for example, which are these giant passive vehicles, is for people to trade baskets of stocks in an active way. People are now day trading ETFs, which is such a bizarre, counterintuitive thing to be doing in some sense. So I think the market can evolve a lot more and you will still see plenty of active trading, plenty of information gathering, and I think prices will still be pretty efficient for the reasons I said earlier.

11:02Makes sense. What role do shareholders have in managing agency conflicts between themselves and the managers of the firms they invest in? So this is a second paper, which we executed on the same topic of the rise of passive and the effects on financial markets, and then this paper really on sort of corporate governance. And the agency conflicts between shareholders and managers is pretty much an evergreen topic in finance. And arguably, it's the original principal agent conflict. There are probably thousands of academic studies going back to Mike Jensen, who recently passed away, rest in peace, back to Berlin means in the early 20th century.

11:39And as usual with most classic questions in economics, even Adam Smith wrote about it. I actually have realized we quoted this in our paper. So I wanted to point out Smith, 1776, the directors of such joint stock companies, being the managers of other people's money rather than of their own, cannot be well expected that they should watch over it with the same anxious vigilance with which the partners in a private co-partnery watch over their own. Yeah, it's been around for a while. Okay. So that matters a lot. Shareholders role in corporate governance. How significant is index fund ownership of individual stocks?

12:12It is significant. The big three passive fund providers, namely BlackRock, Vanguard, and State Street, between them hold 20 or more percent of all the available shares of every single US public corporation. For other countries, other stock markets, the fraction is lower, but they are catching up as money flows in and they continue to try to diversify. And the fraction is continuing to rise everywhere because passive investing continues to rise. The train has left the station. And I should say that passive investors' influence on corporate governance is even larger than that shocking number would suggest because owing to their fiduciary duty, these funds show up at every shareholder meeting and they always vote on every item.

12:56Other investors generally don't. Interesting. That is interesting. I hadn't thought about that. So how are index funds incentives to monitor their portfolio holdings different from those of traditional actively managed funds? It's very difficult to say. It's complicated and it is still an open debate how the incentives of index funds to monitor differ from active funds. If you ask BlackRock or Vanguard or certain of my academic colleagues, they'll say, look, these are gigantic long-term shareholders. And as a result, they have a very strong incentive to monitor their portfolio firms. On the other hand, if you ask others in the industry, or if you ask other of my academic colleagues, I would point at a beautiful classic paper now, 2017 by Lucian Bebchuk, Alma Cohen, and Scott Hurst.

13:46In that paper, they point out that index funds, because of their fundamental business model, they have very little resources or incentives to monitor their portfolio firms. The bottom line is that the fundamental business model of an index fund is polar opposite from the business model of an active fund. Index funds do not try to generate alpha. Their only job is replicate the index as closely as possible, as cheaply as possible. Moreover, the index fund industry is brutally competitive. Index fund investors are shopping now on the basis of individual basis points per year in fees. it's viciously competitive.

14:24And you've seen this race to the bottom where the fees are staggeringly low now. You can park up money in VTI and Vanguard will replicate this giant total market index for you for five basis points a year. It's incredible. So the Bebchak et al. paper argues on that basis that index funds therefore have neither the resources nor the incentives to monitor their portfolio firms. And that controversy is what we wanted to look into and try to get some answers. It's super interesting to think about because I have often thought that what's the difference between large active managers holding most of the assets versus index funds from the perspective of this type of thing.

15:01But there is actually a difference because of their fundamental business model. How do you measure monitoring? How do you measure how well index funds or active funds are doing monitoring the companies they own? So our main measure of monitoring, we look at how funds vote at shareholder meetings on contentious items. Those are items where the firm management and ISS, the third party recommender ISS, Institutional Shareholder Services, made different recommendations on how shareholders should vote. And we see those items as being where the funds really have to show you where their allegiance lies.

15:33I looked up VTI just to be sure. I think the expense ratio is actually 0.03. So it's even lower. Market beta is basically free at this point. So empirically, how well do index funds monitor relative to active funds? Index funds are much more management friendly. For example, we find that across the board on these contentious items, for example, when management recommends a yes vote, but ISS, the third party recommends a no vote, active funds vote yes 44 % of the time, while index funds voted yes 53 % of the time. That's a nine percentage point gap, which in this voting literature in this area is huge.

16:11So we have this agency conflict between the shareholders and the managers and index funds are more often voting with management compared to active funds. That's right. And you'll notice that the active funds come in at 44%. So you're talking about a world 20 years ago where on average on contentious votes, management did not get what they wanted. As we move more and more and more toward passive, recall passive voted management's way 53 % of the time, you're potentially tipping into a world where on average on these contentious items, management gets what they want. Okay. So we talked about the low costs of index funds being potentially part of the overall incentive issue here.

16:50How do the expense ratios of index funds affect their quality of monitoring? So we find that index funds with higher expense ratios, the voting gap actually shrinks. That is to say, they are relatively less management-friendly and they vote a little bit more like active funds would. And I should say this finding is consistent with another classic, fairly recent paper by Jonathan and Katerina Llewellyn. And that paper argues that index funds do in fact have some incentive to monitor based on their fees. So you don't get bonused if you run an index fund on the basis of generating alpha, that's not your job.

17:24But if, Mark, you run VTI and you have some intervention you could do, that would be accretive to firm value. First of all, they point out your fiduciary duty would require you to do that intervention. Second of all, they point out if you can raise one of your portfolio firm's values, your AUM goes up and you collect extra fees on that. And also investors may notice that your returns are looking a little better. And as a result, you may attract more AUM through that indirect channel. And the fees do provide you with an incentive. And our finding is insistent with that story. Intuitively, that seems to make sense.

18:02But wow. So how do we know that index funds aren't engaging with management beforehand and then voting in support of the proposals that they've pre-negotiated? Yeah, this is a really good question. So there are three main pillars as to how shareholders can monitor and make themselves heard. This is corporate finance 101. one. We divide it into voting, exit, and engagement. So we said on voting, there's this really, really sizable gap that we observe. On exit, you almost don't even have to check, but we did go and check just to be sure. And yeah, it turns out that active funds turn over their positions enormously more than index funds do.

18:38So therefore, the threat or the possibility of exit is enormously weaker for index funds. So that leaves just the possibility that they're making it all up on the side of engagement, that they're engaging way more behind the scenes. Now, engagement is very hard to measure. I do have a couple of projects in the hopper that I won't tip my hand yet, but we're working on that. But on this project, we do have one window on engagement because if a mutual fund owns more than 5 % of a particular firm, it's a block holder and it has to file one of two forms with the SEC in order to disclose that fact. So Form 13-D is the form that the fund will file if it has the intent to, there's some legal language, but it's something like the intent to engage with or alter the conduct of the firm.

19:27And then there's also Form 13-G, which the reporting requirements are less onerous, but it requires that the fund has no such intent. So we went and we looked, we scraped the SEC website and we did a bunch of data analysis. And it turns out, interestingly, it's pretty simple to state, index funds always file the second form, 13G. In fact, we could not find a single event in our sample ever in which an index fund filed the activist form 13D, where they stated that they intended to engage or alter the firm's conduct. Man, that's crazy. So the voting index funds are doing worse, but there's this possibility where they're doing engagement behind the scenes and they're always voting with management because they've convinced management to do what they want beforehand through engagement, but they're never filing the form that would suggest that they're actually doing any engagement.

20:15Correct. You want to be a little skeptical, of course. So you say, well, those 5 % blockholder, that's maybe a minority of observations. You're not seeing everything. Well, yes, but those 5 % blockholder holdings are precisely where you would expect them to engage the most because they have the most ownership and the most at stake and they don't. That's wild. How does index fund ownership affect other firm level governance issues? So we find no effect at all on measures of entrenchment, such as think poison pills or staggered boards, things of that nature. On the other hand, those entrenchment measures, dual class share status, another classic measure of entrenchment.

20:52On the other hand, if you think about dual class share status or poison pills, those are very slow moving. You generally need like a super majority vote just to change that. So you might well expect that they'd be very slow to react. On the other hand, we do find pretty clear effects on managerial compensation. A bump to your index fund holdings and a reduction in your active holdings is followed by lower pay performance sensitivity and higher total compensation for the firm's top managers. And that seems pretty clearly worse for firm governance. So then what's your main conclusion on how index funds affect monitoring and corporate governance?

21:30So let's recap. So index funds, we find vote in a way that is significantly more management friendly. They're less prone to exit or engage with their portfolio firms. And increased index fund holdings are followed by a lower pay performance sensitivity and higher compensation for top managers. And overall, it paints a picture that the rise of index funds may be leading to worse oversight and less monitoring. Which is bad. At some point, that's destroying value for shareholders. That's the problem. So you're absolutely right, Ben, that it's going to eventually be value destroying. But even more than that, you can point to Ricardo Zingales and Hart, for example, and other folks who have been pointing out the rise of the desire for socially responsible conduct, socially responsible investing and socially responsible conduct by the firm, so-called stakeholder capitalism.

22:22And worse governance and less monitoring and oversight by your shareholders is worse for all stakeholders. You've got a paper related to that topic too, that we're going to get to in a second. But we've talked about how index funds are not really affecting price efficiency because there's this equilibrium and that's all fine. So that's great. But they're also deteriorating corporate governance, which is not so great. So what are your just general thoughts on are index funds good or is there a problem here? So for the investors who are able now to park their money in VTI and get maximum diversification for, as Mark pointed out, three basis points a year.

22:55This is unquestionably just a gigantic boon. And hats off to Jack Bogle, Vanguard, and all the folks working in the passive fund industry. They've done a great thing. What are the potential down the road, unintended consequences of this? That's the real question of this whole line of my research. So we think of financial capital more broadly in the sense of everything on the right hand of the firm's balance sheet is funding for the firm one way or the other, and that's financial capital. And we generally taxonomize it according to two dimensions, cash flows and control rights. Bonds have very, very defined cash flows and relatively weak control rights, except if you're in default.

23:34Stocks have much hazier cash flows, but stronger control rights, this kind of thing. Now, my dear, dear friend and brilliant co-author, Matt Ringenberg, once put it really nicely. I think we were out drinking bourbon at some place downtown in Salt Lake City, which is where we get all our best ideas. And Matt said, the market for cash flows is really, really competitive and efficient. And the market for control rights really is not. And I think that's a great little aperçu that stuck with me. So on the financial side, there are lots and lots of really strong incentives and money at stake and mechanisms that push us back towards efficient liquid functioning.

24:11On the governance side, if you think about the market for corporate votes or the market for corporate control, much less so. So that's the reason why I suspect that with the continued rise of passive, we will probably still continue to see financial markets functioning well. In fact, if you just look in the very broad patterns over time, financial markets, liquidity, and most measures of efficiency have just been getting better over time over the last two decades or so. If there are unintended consequences to this rise of passive, I think going to see it on the side of corporate governance, the side of control rights.